America Going Deeper Into Debt

April 23, 2018

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How much debt can the U.S. government afford? Nobody knows for sure, but
it’s pushing the envelope like never before -- or at least more than it has
since World War II.

In its latest Global Fiscal Monitor report, the International Monetary Fund
offers an admonishment for the world’s developed nations: Use this period of
economic growth to pay down some of your debt. Pretty much all are aiming to
make some progress, with one notable exception: America.

Thanks to the tax cuts and spending plans Congress has passed under
President Donald Trump, the U.S. government’s debt 1 is now projected to reach 96.2 percent of gross domestic
product by 2028. That’s seven percentage points higher than the
Congressional Budget Office’s 10-year projection from a year ago, and almost as
high as in 1946, when the government had been borrowing heavily to build tanks
and planes for the war.

What's the Limit?

So how much is too much? As the world’s largest economy and the issuer
of its dominant reserve currency, the U.S. gets more leeway than other nations.
Its government bonds are considered the ultimate safe asset, at a time when
such assets are in great demand. When crises hit, investors flock to the haven
of the dollar, driving down U.S. borrowing costs. As a result, the government
hasn’t been punished for over-borrowing to the extent that others have.

As long as interest rates remain low, the U.S. can stabilize its debt
burden with relative ease. The math is simple: The ratio of debt to gross
domestic product will stay the same if the numerator (debt) grows at the same
rate as the denominator (the economy). In the long term, the U.S. economy is
expected to grow at a nominal rate of about 4 percent. And the debt — if nobody
actively adds to it — will grow at the rate of interest, currently forecast to
be a bit less than 4 percent. So all the government needs to do is keep its
primary budget (revenue and spending, excluding interest payments) roughly in
balance, something it achieved as recently as 2007.

But as Italy, Spain and many others can attest, borrowing costs can rise
quite suddenly if investors start to worry about a government’s ability or
willingness to pay. Worse, such concerns are self-fulfilling, because higher
debt-service costs make the burden much harder to bear. A loss of confidence in
the U.S. would be particularly fraught: The government could hardly step in to
calm markets -- as it did back in 2008 -- if its own finances were the source
of distress.

So what could spook investors? One possibility is that they could start
to doubt the government’s capacity to get its debt back down to a level that
has, historically, been considered prudent. The European Union, for example,
asks its members to target a maximum government debt of 60 percent of GDP. It’s
a benchmark that they have lately ignored, and there are other ways of looking at debt
capacity, but advanced nations have also defaulted or taken other radical
measures at lower levels of indebtedness.

Could the U.S. meet such a requirement? Say, over a period of 10 years?
As recently as 2015, when the debt ratio was expected to hit 78.7 percent, this
seemed feasible. Under the CBO’s assumptions for GDP growth and interest rates,
the U.S. would have had to run a primary budget surplus of 2.4 percent of GDP
to get the ratio back down to 60 percent. Based on the latest projections, with
the debt ratio reaching 96.2 percent, the task is much harder: The required
primary surplus would be 4.3 percent.

Getting Less Solvent

As Greece can attest, such austerity can have dire political and
humanitarian repercussions. Also, the U.S. has never done it. Since 1800, the
largest average primary surplus the U.S. has sustained for 10 years was 2.9
percent, and that was during the post-World-War-II boom.

To be sure, governments can reduce debt burdens without resorting to
austerity, though none of the options is particularly attractive.
They can use regulation or other mechanisms to force banks to lend to them at
low rates. If they borrow in their own currency, they can engineer a surprise
bout of inflation, which boosts the denominator without affecting the numerator
-- but this can be hard to control and damage the country’s credit.

Ultimately, it’s hard to know how much a government -- and the U.S. in
particular -- can borrow before things get out of hand. One thing for sure:
It’s a limit best left untested.